An oft heard refrain: I just want to make sure that the small investor isn't hurt. Coincidentally, the definition used for small investor turns out to include the speaker. Though it may sound like I'm picking on BenWP here, my observation is general. Even before reading details of the proposal, I was confident that the proposed change would fall primarily on wealthier investors.
First, because the truly little guy is insulated from capital gain taxation - until one's taxable income exceeds $40,400 (single) or $80,800 (joint), cap gains are taxed at 0%. Second, because (at least as of 20
12) only
1/3 of households even had taxable investment accounts, and I think it's a safe bet that these are largely not lower income households. "It is immediately clear that household income has the strongest relationship with taxable account ownership."
https://www.sec.gov/spotlight/fixed-income-advisory-committee/finra-investor-education-foundation-investor-households-fimsa-040918.pdfThe in-kind transaction loophole existed for all forms of businesses (corporations, funds, etc.) since
1935. Congress began narrowing it in
1969. It was little used until ETFs came along and exploited it. It has never made sense from a tax principle perspective - cap gains cannot simply go **poof**. Logically they should either accrue to the company (RIC) or if passed through, to the recipient.
Throughout the history of U.S. investment companies, in-kind distributions have been exempt from tax at the fund level. As Congress began to limit and finally prohibit in 1986 the tax-free distribution of appreciated property by corporations, it continued to specifically exempt open-end funds from this rule. There is scant discussion in the legislative history for the justification for this exemption or why closed-end funds were not also eligible. Perhaps the simplest explanation for the legislative silence is that when [the tax code was changed to narrow the exemption], in-kind distributions from open-end funds were rare.
Jeffrey Colon, The Great ETF Tax Swindle: The Taxation of In-Kind Redemptions,
122 Penn St. L. Rev.
1 (20
17)
Abstract:
https://ir.lawnet.fordham.edu/faculty_scholarship/722/Paper:
https://ir.lawnet.fordham.edu/cgi/viewcontent.cgi?article=1721&context=faculty_scholarshipAs to
the proposal, it is simplicity itself. Registered investment companies (OEFs and ETFs) are to be treated the same way as other companies. When they sell holdings, they are to recognize capital gains. Regardless of the form of the sale, i.e. regardless of whether they receive cash or fund shares in exchange for the securities they sell.
No more special cases. No special case because they're conducting an in-kind transaction. No special case because they're an OEF or ETF rather than a CEF.
ETFs would be expected to respond by selling their highest cost shares to the AP (authorized participant) rather than their lowest cost shares. At least if they cared about tax efficiency. That's the same method that OEFs use when raising cash to redeem shares.
Regarding Vanguard: Even before Vanguard started selling VIPERs (Vanguard Index Participation Receipts), their index funds tended to be the most tax efficient on the market. There were many years when their broad based index funds did not distribute cap gains. The proposed change should make Vanguard funds (and ETFs) look even better relative to their competition because of demonstrated skill in minimizing taxes.
Vanguard writes: “the ability of mutual funds and ETFs to transact securities in-kind is a longstanding practice that improves outcomes for millions of investors.” Funds could always transact in-kind.
ETFs fundamentally rely upon this ability in order to keep market price close to NAV. The proposed change does not affect their ability to transact in-kind. OEFs sometimes rely upon this ability as well. It is reasonably well known that Sequoia not only reserves the right to redeem shares in kind, but states explicitly that it is likely to do so for redemptions above $250K. Investors benefit because funds are not forced to conduct fire sales to meet large redemptions.
Sequoia Prospectus: It is highly likely that the Fund will pay you in securities or partly in securities if you make a redemption request (or a series of redemptions) in an amount greater than $250,000.
